Last week we discussed a potentially undervalued company in Advance America (AEA). For the purpose of illustrating how cheap the company is relative to its price, it was noted that the company earned $200 million in the last four years. But a reader pointed out that cash flow is even better, as the company has brought in $350 million in just the last two years. There is clearly a large difference between the company's earnings and its operating cash flow. So which metric is the one that investors should use to estimate the firm's potential?

Sometimes operating cash flow is more useful in determining a company's potential, and sometimes net income is more useful. When there is a large difference between the two, the investor must examine the elements of each statement and apply his business sense to determine which one (or combination thereof) describes the firm's future cash flows better. We recently looked at a company where operating cash flows were potentially more useful than net income due to the company's amortizing intangible assets.

With Advance America, the major difference between net income and the company's cash flow is a provision for bad debt expense of around $130 million every year. Advance America makes loans to people who aren't the most credit-worthy. As a result, a large chunk of their loans get written off ever year, of an amount that the company has become pretty good at predicting. However, because this provision is a non-cash expense, it gets added to net income to form part of the company's operating cash flow. But these bad debts are real, and get charged off every year; they just don't form part of "operating cash flows" as the company defines them. Ignoring this very real cost is a mistake that could result in a major overestimation of this company's earnings potential.

Investors must avoid an over-reliance on any one of the company's financial statements. Instead, they should be used together to form a descriptive picture of a company's operating situation. Only then can the investor understand what is going on inside the business, which puts him in a better position to determine the business' intrinsic value.

About the author:

Saj Karsan

Saj Karsan founded an investment and research firm that is based on the principles of value investing. He has an MBA from the Richard Ivey School of Business, and an undergraduate engineering degree from McGill University.

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